The government creates an incentive to invest in a 401(k) by offering tax breaks on the money you contribute. However, the tax deduction only goes so far. While the money you allocate to the plan won’t be subject to income taxes until you withdraw them upon retirement, you’ll still pay the taxes for the Federal Insurance Contributions Act, commonly referred to as FICA, on your current year's return.
Not All Taxes Deferred
401(k)s are considered tax-deferred plans. That means that the contributions you make into the plan are not subject to that year's income tax. If you’re contributing a percentage of your salary, this increases the amount that enters the account, because it’s based on your gross income, not the amount that's actually in your paycheck once tax withholdings are deducted. It might not seem like a big deal now, but compound the interest earned on that amount over decades, and it makes a huge difference by the time you retire. You don’t pay income taxes on that money until you withdraw it in retirement.
FICA taxes are based on your gross income, because the Internal Revenue Service takes a percentage of your salary off the top to fund Social Security and Medicare. Because of that, contributing to your 401(k) doesn’t reduce the amount of money you’ll owe at tax time for those categories. As of publication, you pay 6.2 percent of those earnings for Social Security and 1.45 percent for Medicare, whether you took your salary in your check today or squirreled it away for tomorrow.
Check The Boxes
You’ll see evidence of the different income subject to FICA and income taxation when you get your W-2s from your employer. Box 1 on your W-2 contains your wages for income tax purposes, which does not include your 401(k) contributions. If you do contribute to such a plan, boxes three and five will be larger. These, labeled as “Social Security wages” and “Medicare wages and tips,” reflect the amounts you’ll use to determine what you owe for those taxes.
Pay Now, Not Later
On a positive side, taking out the FICA wages now saves you a bit of money down the road. When you withdraw money from your 401(k), you’ll have to pay income taxes on it, as well as a 10 percent penalty if you get the funds before you’re 59 1/2 years old. However, you won’t have to pay FICA taxes at that point, because you already paid those taxes on the money you put in there.